Why some foreign banks might fail new round of stress tests

WASHINGTON — A number of foreign banking powers will soon face a day of reckoning under a more advanced version of the Federal Reserve's stress test regime.

This June, consolidated U.S. operations of foreign banks, known as intermediate holding companies, or IHCs, will undertake their first full examination under the Comprehensive Capital Analysis and Review and Dodd-Frank Act Stress Tests for the first time. IHCs participated in the stress tests last year, but this year their results will actually be published. Many of those banks will also be subject to the "qualitative" assessments from which other banks with less than $250 billion have recently been exempted.

Even though the results for foreign firms in prior, nonpublic stress test iterations are unknown, observers say some foreign banks could stumble out of the gate in the public version.

“We don’t know the exact results of last year’s CCAR, but I’m sure there’s a learning curve, and I would assume you will see in [this year’s] results that … the learning curve continues,” said Mike Silva, chair of the financial services practice at DLA Piper and a former official at the Federal Reserve Bank of New York. “At least some firms may not pass.”

Banks typically face both technical and financial challenges in complying with CCAR, but Karen Shaw Petrou, managing partner at Federal Financial Analytics, said that part of the reason IHCs face a particularly uphill battle is because of the inherently dichotomous nature of their supervisory structure.

“Very simply, their parent company is not a U.S. company, and the parent company is subject to both very different laws and often a totally different cultural expectation of how to run a really big bank,” Petrou said. “That’s the whole rationale for IHCs. To put the biggest U.S. operations under a U.S.-specific governance structure solves for some of the problem … but the fact remains that these are subsidiaries of foreign banks, and foreign banks are different.”

The stress tests — particularly CCAR — are widely viewed as the most consequential supervisory innovation to emerge from the financial crisis, and arguably the most important supervisory innovation in a generation.

Banks designated as systemically important financial institutions, or SIFIs, must subject their balance sheets to a battery of stress scenarios developed by the Fed, and those banks’ capital levels may not dip below the applicable minimum capital standards, even under severely adverse conditions. If they do fall below those levels or if the Fed determines that the bank’s internal controls and models are not adequate, the agency can suspend dividend payments or apply other supervisory penalties.

Banks in recent years have gotten much better at passing the stress tests, but the 2018 stress tests scenarios are substantially harder than in prior years, in large part because of the countercyclical design of the scenarios. As the economic baseline improves, the tests have to imagine scenarios that require the economy to fall even farther in order to simulate a crisis on the level of 2008.

The Fed in 2014 issued its rules requiring foreign banks with more than $50 billion in non-branch U.S. assets to establish IHCs. The requirement allows the central bank to thread the regulatory needle of subjecting foreign-based banks to U.S. rules without overstepping its jurisdiction. The rules required applicable banks to establish their IHCs by July 1, 2016, and undergo a trial run of the stress tests in 2017. This year is the first full stress test.

This year, there are 38 banks subject to CCAR, 11 of which are IHCs (and six of those IHCs are taking the stress test for the first time). Of the 18 total banks subject to the qualitative assessment, seven of those are IHCs.

Some banks — Deutsche Bank Trust USA, Santander Holdings USA, TD Group US Holdings, BMA Financial, HSBC North America and MFUG Americas — opted to designate an existing Bank Holding Company as their IHC. That is why those banks have been under the CCAR regime for several years, while other firms are only coming on line in this cycle.

DB USA has superseded Deutsche Bank Trust Corporation as Deutsche Bank’s designated IHC and is subject to the qualitative assessment, though Deutsche Bank Trust was not in 2017. Deutsche Bank Trust faced qualitative objections in 2015 and 2016, as did Santander in 2016.

That landscape changes fairly dramatically if the House passes the Senate’s regulatory reform bill — a prospect that seems to have become more likely in recent days.

That bill would raise the SIFI asset threshold from $50 billion to $250 billion, while giving the Fed the discretion to apply enhanced prudential standards, such as stress testing, to individual banks with between $100 billion and $250 billion in assets. IHCs, however, would not be affected by that change, and Fed Vice Chairman for Supervision Randal Quarles said last month that “the overall IFC framework, I think, has been working fairly well.”

A practical effect of the Senate bill would be that a larger proportion of CCAR-tested banks would be IHCs. And while Quarles has mused about the future of the qualitative objection, so long as it remains in place, IHCs will represent a substantial portion of the institutions subject to those objections.

Silva said there was no structural reason why IHCs could not comply with the stress tests — after all, most of them have passed through most of the CCAR cycles. But the U.S. stress testing regime and other risk management standards are different than what those institutions’ parent companies may have been designed for, and meeting those new demands often takes time, he said.

“It’s a good example of the many extra costs of doing business in the U.S.,” Silva said. “The U.S. is a very important market. Most large banks want to be here — need to be here, to some degree. If they want to be in this market, there are extra costs and challenges.”

Phillip Swagel, a professor at the University of Maryland’s School of Public Policy, said those differences are akin to challenges that non-U.S. banks faced after Congress passed the tax bill last year.

One provision of that law, known as Base Erosion and Anti-Abuse Tax, or BEAT, taxes payments from domestic subsidiaries to foreign affiliates. That provision has caused some headaches for U.S. subsidiaries of foreign banks with certain debt holdings required under separate rules that is now potentially subject to tax because of BEAT.

“We see issues like this with the tax law,” Swagel said. “I wonder if there are other instances like that, where banks have set themselves up in a particular way, and now they’re going to be subject to this new regime, and ... some of the choices that they’ve made run afoul of it. I can’t think of anything in particular, but it doesn’t mean it’s not there.”

Swagel added that, depending on how the results come out, the Fed could withhold penalty for qualitative shortcomings or rethink the IHC structure altogether. If, for example, many of the IHCs face the same qualitative problems that can be traced to a specific aspect of the IHC rules, the Fed’s leadership would be less likely to hold a hard line on the IHC rule because it was instituted under a prior administration.

“I can imagine that the Fed leadership isn’t as attached to the IHC construct,” Swagel said. “I can imagine a new leadership, if it causes problems, saying, ‘Yeah, OK, we’re open to changing it.’ ”

Silva wasn’t so sure the Fed board of governors is eager to reopen the IHC issue, as evidenced in part by its decision to exempt IHCs from its proposal to revise the roles of bank boards of directors and management. Under the IHC rules, an IHC has its own board of directors, separate from the board of directors for the parent company.

“IHCs were specifically exempted from that proposal, in part because there’s this tricky question of exactly what are the expectations for a board that presumably, at the end of the day, can’t really say no to the global board,” Silva said.

Petrou said that even though the Fed is reconsidering many aspects of the stress testing program, neither IHCs nor other large banks should expect that changes to the tests will amount to an easier ride down the road — even as early as next year. The Fed’s proposals on the stress capital buffer and enhanced Supplementary Leverage Ratio, as well as the application of new accounting rules for credit losses, add up to a simpler supervisory regime that enshrines CCAR in the center.

“I know the result of the current 2018 round is that it’s going to be a higher capital number for most banks, because it’s a much tougher test,” Petrou said. “The total impact of all of this is to make a stress-tested credit risk-based [capital] number the binding constraint for virtually all of the biggest banks, and to ensure that the large regionals get capital relief and the large G-SIBs stay screwed.”